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Investment Criteria
Timothy R. Mayes, Ph.D.
FIN 3300: Chapter 9
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What is Capital Budgeting?
Capital budgeting refers to the process of deciding
how to allocate the firms scarce capital resources
(land, labor, and capital) to its various investment
alternatives
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Overview
All of these techniques attempt to compare
the costs and benefits of a project
The over-riding rule of capital budgeting is to
accept all projects for which the cost is less
than, or equal to, the benefit:
Accept if: Cost s Benefit
Reject if: Cost > Benefit
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The Six Criteria
There are six criteria that we will use:
The payback period
The discounted payback period
Internal rate of return (IRR)
Modified internal rate of return (MIRR)
Net present value (NPV)
Profitability index (PI)
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The Example
We will use the following example to demonstrate
the techniques of capital budgeting
Assume that your company is investigating a new
labor-saving machine that will cost $10,000. The
machine is expected to provide cost savings each
year as shown in the following timeline:
0 1 2 3 4 5
2000 2500 3000 3500 4000 -10,000
If your required return is 12%, should this machine
be purchased?
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The Payback Period
The payback period measures the time that it takes to
recoup the cost of the investment.
If the cash flows are an annuity, then we can simply
divide the cost by the annual cash flow to determine
the payback period
Otherwise, as in the example, we subtract the cash
flows from the cost until the remainder is zero
The shorter the payback period, the better
Generally, firms will have some maximum allowable
payback period against which all investments are
compared
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The Payback Period: An Example
For our example project, we will subtract the cash
flows from the initial outlay until the entire cost is
recovered:
10,000 Cumulative Payback
- 2,000 1 year
= 8,000
- 2,500 2 years
= 5,500
- 3,000 3 years
= 2,500 3 years < Payback < 4 years
Since it will take 0.7143 years (= 2500/3500) to
recover the last 2,500, the payback period must be
3.7143 years
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Problems with the Payback Period
The payback period suffers from two primary
problems that limit its usefulness in evaluating
investments:
It ignores the time value of money
It ignores all cash flows beyond the payback period
Still, it has a couple of redeeming qualities
It is quick and easy to calculate
It gives a measure of the liquidity of the project
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The Discounted Payback Period
The discounted payback period is exactly the same as
the regular payback period, except that we use the
present values of the cash flows in the calculation
Since our required return (WACC) is 12%, the
timeline with the PVs looks like this:
The discounted payback period is 4.82 years
Note that the discounted payback period is always
longer than the regular payback period
0 1 2 3 4 5
1785.71 1992.98 2135.34 2224.31 2269.71 -10,000
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Problems with Discounted Payback
The discounted payback period solves the time value
problem, but it still ignores the cash flows beyond the
payback period
Therefore, you may reject projects that have large
cash flows in the outlying years that make it very
profitable
In other words, any measure of payback can lead to a
focus on short-run profits at the expense of larger
long-term profits
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The Internal Rate of Return
The internal rate of return (IRR) is the discount rate
that equates the present value of the cash flows and
the cost of the investment
Usually, we cannot calculate the IRR directly, instead
we must use a trial and error process
For our example, the IRR is found by solving the
following:
( ) ( ) ( ) ( ) ( )
10 000
2000
1
2500
1
3000
1
3500
1
4000
1
1 2 3 4 5
, =
+
+
+
+
+
+
+
+
+ IRR IRR IRR IRR IRR
In this case, the solution is 13.45%
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Problems with the IRR
The IRR is a popular technique primarily because it is
a percentage which is easily compared to the WACC
However, it suffers from a couple of flaws:
The calculation of the IRR implicitly assumes that the cash
flows are reinvested at the IRR. This may not always be
realistic.
Percentages can be misleading (would you rather earn 100%
on a $100 investment, or 10% on a $10,000 investment?)
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The Modified Internal Rate of Return
The modified IRR (MIRR) is the average annual rate
of return that will be earned on an investment if the
cash flows are reinvested at the specified rate of
return (usually, the WACC)
To calculate the MIRR, first find the total future value
of the cash flows at the reinvestment rate, and then
apply the formula:
MIRR
FVCF
IO
N
= 1
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The MIRR: An Example
To calculate the MIRR for our example, first find the
FV of the cash flows at 12% (the WACC):
( ) ( ) ( ) ( )
FVCF = + + + + = 2000 112 2500 112 3000 112 3500 112 4000 18 342 56
4 3 2 1
. . . . , .
This is the amount that you will have accumulated
by the end of the life of the investment
Now, find the average annual rate of return:
MIRR = =
18342 56
10000
1 12 899%
5
.
.
Since the MIRR is greater than the WACC, this
project is acceptable
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The Net Present Value
The net present value (NPV) is the difference
between the present value of the cash flows (the
benefit) and the cost of the investment (IO):
NPV PVCF IO =
In other words, this is the increase in wealth that the
shareholders will receive if the project is accepted
All projects with NPV greater than or equal to zero
should be accepted
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The NPV: An Example
NPV is calculated by subtracting the initial outlay
(cost) from the present value of the cash flows
Note that the discount rate is the WACC (12% in this
example)
( ) ( ) ( ) ( ) ( )
2000
112
2500
112
3000
112
3500
112
4000
112
10000 408 06
1 2 3 4 5
. . . . .
. + + + +
|
\

|
.
|
|
=
Since the NPV is positive, the project is acceptable
Note that a positive NPV also means that the IRR is
greater than the WACC
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The Profitability Index
The profitability index is the same as the NPV, except
that we divide the PVCF by the initial outlay:
PI
PVCF
IO
=
Accept all projects with PI greater than or equal to
1.00
For the example, the PI is:
PI = =
10 408 06
10 000
10408
, .
,
.